Behavioural Finance Flashcards
The behavioral finance perspective, behavioral biases of individuals, and behavioural finance and the investment process
5 belief-perseverance biases
(cognitive errors)
Conservatism
Representativeness
Illusion of control
Confirmation
Hindsight
Conservatism bias
Maintains prior views / forecasts by inadequately incorporating new information
Overweights past information compared to new
Consequences and mitigation of conservatism bias
Consequences:
- Slow to update view / forecast when presented with new information
- May choose to maintain prior belief than to deal with mental stress of updating beliefs when given complex data
Mitigants:
- Properly analyse and weight new information to dertemine its value (e.g. using Baye’s theorem)
- Seek professional advice if information is difficult to interpret
Representativeness bias
New information is classified based on past experience or classification, such as using heuristics (e.g. if-then assumptions or rule-of-thumb), instead of rigorous analysis
2 types including: base rate neglect (overweights new info) and sample size neglect
Consequences and mitigation of representativeness bias
Consequences:
- May lead to statistical or information-processing errors
- Could produce incorrect understanding that persists and biases all future thinking about the information
Mitigants:
- Better understand laws of probability and statistical analysis
Illusion of control
When an individual thinks they can control or affect an outcome when they can’t
Consequences and mitigation of illusion of control bias
Consequences:
- Leads to excessive trading > Increases transaction costs > Lowers overall portfolio returns
- Overconcentrate in own stock thinking they can control the outcome of the price
Mitigants:
- Objectively review past trades including all winning and losing trades to identify tendency
Confirmation bias
Looks for (and notices) information that confirms their existing beliefs, and ignore or undervalue what contradicts their beliefs
Consequences and mitigation of confirmation bias
Consequences:
- Could hold onto investment for tool long due to overconfidence in initial beliefs
- Example: Investor holding too much employer stock
Mitigants:
- Seek out contrary views and further information
- Re-evaluate after every change in company fundamentals
Hindsight bias
Selective memory of past event, actions, or what was knowable in the past
Consequences and mitigation of hindsight bias
Consequences:
- Tendency to see things as more predictable than they really are
- Results in excessive risk taking, overconcentration of stock positions
- Can become critical of the performance of others (because you “knew it all” along) and unfairly dismiss managers
Mitigants:
- Recognise and come to terms with own mistakes
- Record and objectively examine past investment decisions
4 information-processing biases
(cognitive errors)
Framing
Anchoring & adjustment
Mental accounting
Availability
Framing bias
Decisions are affected by the way in which the question or data is framed
Consequences and mitigation of framing bias
Consequences:
- Fail to properly assess risk and end up overly risk-averse or risk-seeking
- Choose suboptimal risk for their portfolio / assets based on the way a presentation is made
Mitigants:
- Detect by asking whether one’s decision is based on realising a gain or a loss
- Acknowledge the imapct of loss aversion on one’s willingness to take risk
- Use more appropriate analysis e.g. compare current price to instrinsic value
Anchoring & adjustment
Estimates probabilities based on an initial default view (anchor) which is adjusted up/down to reflect subsequent information and analysis
Overweight on statistically arbitrary, psychologically determined anchor points
Consequences and mitigation of anchoring & adjustment
Consequences:
- May stick too closely to original estimates when new information is learned
Mitigants:
- Don’t rely on past prices or market levels to influence decisions
- Observe changes in company fundamentals
- Concentrate on the future potential of the company to influence buy/sell decisions
Mental accounting
Money is treated differently depending on how it is categorised
Consequences and mitigation of mental accounting
Consequences:
- Structuring investments into discrete buckets without regard for correlations among assets
- Failing to lower portfolio risk by combining assets with low correlation
- Overemphasis on income generating assets at the expense of eroding principal in the process, resulting in lower total return
Mitigants:
- Combine all assets into one summary to see the true asset allocation of various mental account holdings
- Create a portfolio strategy taking all assets into consideration
- Focus on total return, not just investment income
Availability bias
Undue emphasis on the information that is readily available or easily recalled. Includes:
- Retrievability (easy to recall)
- Categorisation
- Narrow range of experience
- Resonance
Consequences and mitigation of availability bias
Consequences:
- Choose manager / investment based on advertising or recalling names they’ve heard
- Limit investment choices to what’s familiar and fail to consider alternatives > Results in under-diversification and/or inappropriate asset allocation
- Overreact to recent market conditions while ignoring data on historic performance
- Over emphasis on events with large media attention/advertising
Mitigants:
- Maintain carefully researched and constructed IPS with appropriate research and analysis of all decisions and a long-term focus
- Ask “where did I hear this idea?”
6 emotional biases
Loss-aversion
Overvonfidence
Self-control
Endowment
Regret-aversion
Status quo
